The need for macroeconomic stability

Growth is good, but growth with stability is better, especially in a poor country where so many people live at the margin. For the Reserve Bank of India (RBI), it means ensuring growth does not exceed our potential, adopting prudential policies that reduce our risk, and building sufficient buffers that the country is protected against shocks.  
HAVING YOUR CAKE AND EATING IT TOO: INTEREST RATES AND THE EXCHANGE RATE: This mission, however, exposes the central bank to criticism. If we try and bring down inflation, interest rates will remain higher than borrowers desire. If inflation comes down, the currency will depreciate less than some exporters desire. If we push the banks to clean up, banks may be less tolerant towards habitual non-payers. Whatever we do, someone will object. The RBI then becomes the favourite scapegoat for underperformance - if exports are not picking up, it is because interest rates are too high and because the exchange rate is too strong.  
Unlike the complainants, the RBI does not have the luxury of economic inconsistency. If we start buying dollars in a big way to depreciate the exchange rate, we will be able to buy fewer government bonds if we are to maintain control over liquidity. The consequence will be higher interest rates in bond market. Moreover, the depreciated exchange rate will mean higher inflation, which in turn will mean higher policy interest rates given the inflation objective the government has set for us. Once again, this means higher interest rates. Just look at Brazil or Russia to understand you cannot have a significantly depreciated exchange rate and lower interest rates at the same time if you want stable growth!  
FIRST YEAR ECONOMICS: THERE IS NO FREE LUNCH. RBI DIVIDEND POLICY: A fundamental lesson in economics is there is no free lunch. This can be seen in the matter of the RBI dividend: Some commentators seem to suggest that public sector banks could be recapitalised entirely if only the RBI paid a larger dividend to the Government. Let me explain why matters are not so simple. If what follows is complicated, trust me, it is. But pay attention, students, especially because it is about your money. I am sure you will understand.   
How does the RBI generate surplus profits? We, of course, print the currency held by the public, as well as issue deposits (i.e. reserves) to commercial banks. Those are our fixed liabilities. As we issue these liabilities, we buy financial assets from the market.  We do not pay interest on our liabilities. However the financial assets we hold, typically domestic and foreign government bonds, do pay interest. So we generate a large net interest income simply because we pay nothing on virtually all our liabilities.   
Our total costs, largely for currency printing and banker commissions, amount to only about 1/7th of our total net interest income. So we earn a large surplus profit because of the RBI's role as the manager of the country's currency. This belongs entirely to the country's citizens. Therefore, after setting aside what is needed to be retained as equity capital to maintain the creditworthiness of the RBI, the RBI Board pays out the remaining surplus to the RBI's owner, the Government.  
The RBI Board has decided it wants the RBI to have an international AAA rating so that RBI can undertake international transactions easily, even when the Government is in perceived difficulty - in the midst of the Taper Tantrum, no bank questioned our ability to deliver on the FCNR(B) swaps, even though the liability could have been tens of thousands of crores. Based on sophisticated risk analysis by the RBI's staff, the Board has decided in the last three years that the RBI's equity position, currently around 10 trillion (10 lakh crores), is enough for the purpose. It therefore has paid out the entire surplus generated to the Government, amounting to about Rs 660 billion (66,000 crores) each in the last two years, without holding anything back. This is of the order of magnitude of the dividends paid by the entire public sector to the Government.  In my three years at the RBI, we have paid almost as much dividend to the government as in the entire previous decade. Yet some suggest we should pay more, a special dividend over and above the surplus we generate.
Even if it were legally possible to pay unrealised surplus (it is not), and even if the Board were convinced a higher dividend would not compromise the creditworthiness of the RBI, there is a more fundamental economic reason why a special dividend would not help the Government with its budgetary constraints.  
Here's why: Much of the surplus we make comes from the interest we get on government assets or from the capital gains we make off other market participants. When we pay this to the Government as dividends, we are putting back into the system the money we made from it - there is no additional money printing or reserve creation involved. But when we pay a special dividend to the government, we have to create additional permanent reserves, or more colloquially, print money.
Every year, we have in mind a growth rate of permanent reserves consistent with the economy's cash needs and our inflation goals. Given that budgeted growth rate, to accommodate the special dividend we will have to withdraw an equivalent amount of money from the public by selling government bonds in our portfolio (or alternatively, doing fewer open market purchases than we budgeted).  
This is not strictly true. Our earnings on foreign exchange assets come from outside the system, so when we pay this to the Government as dividend, we are printing additional money. We do account for this.  
Of course, the Government can use the special dividend to spend, reducing its public borrowing by that amount. But the RBI will have to sell bonds of exactly that amount to the public in order to stick to its target for money creation. The overall net sale of Government bonds by the Government and the RBI combined to the public (that is, the effective public sector borrowing requirement) will not change. But the entire objective of financing Government spending with a special RBI dividend is to reduce overall Government bond sales to the public. That objective is not achieved!
The bottom line is that the RBI should transfer to the government the entire surplus, retaining just enough buffers that are consistent with good central bank risk management practice. Indeed, this year the Board paid out an extra Rs 80 billion (8,000 crores) than was promised to the Government around budget time. Separately, the government can infuse capital into the banks. The two decisions need not be linked. There are no creative ways of extracting more money from the RBI - there is no free lunch! Instead, the Government should acknowledge its substantial equity position in the RBI and subtract it from its outstanding debt when it announces its net debt position. That would satisfy all concerned without monetary damage.
If what I have said just now seems complicated, it is, but it is also the correct economic reasoning. Similar detailed rationales lead us to turn down demands to cut interest rates in the face of high inflation, to depreciate or appreciate the exchange rate depending on the whim of the moment, to use foreign exchange reserves to fund projects, to display forbearance in classifying bad loans or waived farmer loans as NPAs, and so on…  
We have been tasked with a job of maintaining macroeconomic stability, and often that task requires us to refuse seemingly obvious and attractive proposals. The reason why we have to do what we have to do may not be easy for every unspecialised person, even ones with substantial economics training, to grasp quickly. Of course, we still must explain to the best of our ability but we also need to create a structure where the public trusts the central bank to do the right thing. This then is why we need a trusted independent central bank.
CENTRAL BANK INDEPENDENCE: In this environment, where the central bank has to occasionally stand firm against the highest echelons of central and state government, recall the words of my predecessor, Dr. Subbarao, when he said "I do hope the Finance Minister will one day say, 'I am often frustrated by the Reserve Bank, so frustrated that I want to go for a walk, even if I have to walk alone. But thank God, the Reserve Bank exists.'"  I would go a little further. The Reserve Bank cannot just exist, its ability to say "No!" has to be protected. At the same time, the central bank cannot become free of all constraints, it has to work under a framework set by the Government. This requires a number of actions. [The last part of the discourse will be published on Saturday, September 10.]
This is a slightly edited version of the last public speech Raghuram Rajan gave as RBI Governor on September 03, 2016 at Stephen's College, New Delhi, link: https://rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1021. Rajan left RBI the next day, September 04.